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Real estate prices are very highBeing a buyer in today’s hyper-competitive Bay Area market can be discouraging. You can put the odds in your favor, though. Just be aware of the basics and keep your expectations in line with reality.

Let’s start with the “reality” part.

Prices

Prices here are stratospheric. There’s nothing we can do about that fact, but you should keep in mind that when a Realtor lists a home at a certain price, they have already researched earlier sales of similar homes in the area to arrive at an offering price that is likely to draw an offer (or offers). A property listed at, say, $750,000 may seem drastically overpriced to you, but a seller is very unlikely to accept a price far below that figure. In those common instances where multiple people are vying to buy the same prices, sales above asking price are not at all uncommon.

Competition

Inventory all across the Bay Area is in short supply, so properties sell very quickly—often in a matter of days. Because of this fact, buyers have very little opportunity to “mull over” a possible purchase. Taking a few days to decide to make an offer on a home is very likely to mean someone else gets it.

Competing with all-cash offers

If a seller receives two offers netting them precisely the same amount of cash at close, but one has a larger down payment, that will almost always be the one they’ll accept. The reason for this is the misinformed belief that getting a mortgage is insanely difficult, and the buyer with the larger down payment has a better chance of ultimately getting funded. This is simply wrong, but sellers—and their agents—continue to believe it.

Dealing with “rejection”

Accept the likelihood that you may not get the first property you like and offer to buy. It’s disappointing, but it is not a personal rejection. It is just the reality of today’s marketplace. If the seller accepts someone else’s offer, just brush yourself off and go to the next house that meets your needs. If you keep at it, you WILL succeed.

Now that I’ve spelled out the unattractive reality, I’ll suggest some strategies to succeed in your quest for home ownership.

Your financing

No seller will seriously consider any offer unless the buyer provides convincing evidence that they’ll be able to get their loan. You may have heard the term, “prequalification.” You should now eliminate that word from your vocabulary. A “prequal” is meaningless; it is essentially a mortgage loan officer’s opinion about your ability to qualify for a mortgage. They will have pulled your credit report and possibly taken a loan application. Based on that basic information, the loan officer writes a “prequal letter” indicating that you are qualified for a purchase of a certain amount.

Sellers (and their agents) are highly skeptical of these kinds of letters because they have been burned a few times. What you want is a preapproval. This means that your lender will have gotten all the documentation needed to approve your loan. They will have verified your income and assets using pay stubs, W2s, possibly tax returns and bank statements. Their preapproval letter should outline exactly what they have done to preapprove your loan.

If your financial situation is up to interpretation in any way—such as a self-employed borrower, a wage earner who receives bonuses and/or overtime, someone who receives income from rental property—you should ask for a “TBD approval.” This means that the lender’s underwriter has fully reviewed and approved your application even though the property is To Be Determined. This way, the seller will know that your loan has been fully approved, waiting only for the purchase contract, title report and appraisal. This is by far the most convincing and effective type of letter to accompany your offer.

Asset documentation

When you’re making your offer, it’s a good idea to document the source of your cash to buy. You can do this with a recent bank statement showing that you have the wherewithal to close. Redacting (blanking out account numbers) is completely acceptable.

Letter to the seller

Selling a home can be an intensely personal and emotional experience. You may be able to tilt the odds in your favor by writing a personal letter to the seller to include with your offer. You’d talk about how much you appreciate their home and look forward to raising your family there if they accept your offer.

I’ll be the first to admit that this “love letter” approach is cheesy; but there is absolutely no downside to doing this. I advised a couple to do this a few years ago. They went completely over the top with their letter—and prevailed over several other competing offers. It was such a lovely story I wrote about it—and included their excellent (and effective) letter in an earlier post.

I should also mention dealing with the high prices—and payment shock—in our market. The effect of rising prices is exacerbated by the steady (and expected) upward drift of rates since the first of the year. You may be able to soften that payment shock a couple of different ways. Here are some possibilities to consider:

Make a larger down payment

If you have the ability (and willingness) to increase your down payment, you’ll obviously have to pay on a smaller loan—but you may also get a small benefit in rate. Every little bit helps.

Look to first-time buyer programs

Buyers and their agents tend to think “down payment assistance” when they hear about first-time buyer programs. There are more choices in this area than getting help with the down payment. One of the most useful—and least well known—is tax credits available for many first-time buyers. There are some restrictions for these credits, but if you qualify, you’ll be able to claim 20% of the mortgage interest you pay every year as a tax credit. This means that the amount is subtracted from the actual taxes you owe in that year. If you pay $20,000 mortgage interest, your tax credit will be $4,000, so if your total income tax bill comes to $8,000, you’ll now owe $4,000. You get the credit each year for as long as you own the property and live there.

Consider your credit score

Most mortgages are ultimately sold to Fannie Mae, Freddie Mac or (in the case of FHA or VA loans) Ginnie Mae. Fannie and Freddie use “risk-based pricing.” This means that they adjust your interest rate based on a combination of your credit score and the loan-to-value ratio. Although the minimum score required for a conventional loan is 620, the rate for a borrower with that score will be approximately .75% higher than for a borrower with a score of 740 or higher. There are several steps in between, so if your credit score is close to one of the rate thresholds, you may be able to save thousands of dollars by optimizing your score by even a few points if it gets you into a better pricing bracket. These risk-based adjustments are consistent across all lenders.

Mortgage insurance choices

If your down payment is less than 20%—and smaller down payments are definitely the norm—the lender will require mortgage insurance(MI) to limit their risk. Buying a home for, say, $550,000 with a 10% down payment, you’ll pay $169 per month if your credit score is 740 or higher. With a down payment of 5%, the monthly insurance will go to $257 per month.

You can avoid that monthly MI payment by selecting “single premium MI.” As the name implies, you make a single payment in lieu of a monthly payment. For a 90% loan, the one-time premium is less than 2% of the loan amount—and it is added to the base loan amount. It does not come out of your pocket. Even though your loan amount will be a bit higher, your monthly payment will be significantly lower because you won’t pay the monthly insurance premium.

Getting into the Bay Area real estate market can be daunting. You may have some moments of discouragement; but if you take some time to prepare, you’ll be fine.

If you’d like a detailed action plan for your own situation, just give us a call: 925-383-2846.

You CAN do this!

Federal ReserveThe Fed Open Market Committee (FOMC) voted today to increase the Federal Funds Rate by .25%. This was widely expected, but people still ask us, “Is the Federal Reserve going to lower mortgage rates anytime soon?”

We get the question often enough that now would be a good time to explore how mortgage rates work.

Fannie and Freddie’s Role

Banks ultimately sell the vast majority of the residential mortgages they fund to investors. The best known of these–and the largest–are Fannie Mae and Freddie Mac. We refer to them as Government Sponsored Enterprises, or GSEs. They are private corporations presently in conservatorship in the wake of the 2008 meltdown.

Fannie and Freddie do not make loans. They buy them from lenders like Pinnacle, then pool them into a type of bond called Mortgage Backed Securities (MBS). These bonds are bought and sold by investors.

Bond Prices Fluctuate

The price of the bonds fluctuates according to market activity, in the same way that a company’s stock goes up and down as invstors buy and sell them. When the price of the MBS goes up, rates go down. This is because lenders get a higher price for the loans they sell to Fannie and Freddie, so they can lower their rates to borrowers.

Investors decide to buy or sell bonds largely driven by fears of future inflation. If they believe inflation will pick up more than expected, the bonds become a lot less attractive to them, so they sell. That makes their price go down, and rates go up. Remember that: Fears Of Inflation.

What the Federal Funds Rate Does

FEderal REserve building

The Federal Reserve, our central bank, uses the Federal Funds Rate to stimulate the economy (lower rates) or slow it down to keep inflation from getting out of hand (higher rates). Increasing the Federal Funds rate, as they did today and will likely do three more times this year, was a proactive step in a recovering economy to keep it from growing too fast. In other words, they have tapped the economic brakes on the economy to keep it from spinning out of control (inflation). Consumers will see the effect of this increase in the cost of credit cards and HELOCs, both of which determine their rates by the Prime Rate, which in turn follows the Federal Funds rate.

The Future for Mortgage Rates

Now that the Fed has raised that one rate, what’s going to happen to interest rates?

Looking just at the bond action today, we can say that they will go down a bit–a very tiny bit. Investors have stepped back into the market to buy bonds again, now that they know the Fed’s decision. That has caused to price of the MBS to go up a bit, lowering rates.

I can hear you wondering why raising rates at the Fed level would cause mortgage rates to go down. Why is that? Remember “fears of inflation?” The investors believe the Fed is being vigilant and proactive, paying attention to inflation, the number one enemy of fixed-income investments like Mortgage Backed Securities. So, with the Fed’s announcement today, investors heave a big sigh of relief and go back to buying bonds, pushing their prices back up and rates down slightly.

What to Do Now

Mortgage rates have been artificially low for a number of years because the Federal Reserve entered the market directly, buying zillions of dollars in MBS (actually, they presently hold slightly less than $1.8 trillion in MBS. I’ll call that close to a zillion). As they have stopped that massive buying effort, we have seen rates gradually increase. In all likelihood, they’ll continue to increase a bit all year.

What does this mean for you, as an owner or prospective buyer of real estate?

If you’re hoping for lower rates, you’re likely to be disappointed. If you are hoping to buy or refinance, it is better to do it sooner, rather than later, since rates are likely to be higher int he future than they are today.

How much house do I qualify for?


One of the most frequent questions we get is, “How much house can I  buy with my income?” Recently, a reader asked us that question. He mentioned that he and his new wife earn $110,000 annually. He wanted to know first whether it was possible to buy a house in the Bay Area. Here’s what I told him:

Yes indeed. How much home you can buy depends on three things:

  • Your down payment
  • Your credit score
  • Your other debt payments.

Debt-to-Income Ratio

Lenders make lending decisions based on “debt to income ratio,” or DTI. We calculate it by adding up the total house payment including taxes, insurance and mortgage insurance, if any, plus any monthly debt obligations with ten months or more remaining. This would include car payments, student loans, credit card minimums and alimony/child support. The sum is called “total debt.” That number, divided by your gross monthly income, produces the DTI. Lenders will allow a DTI as high as 50% for conventional loans.

Down Payment

Your down payment will obviously affect your payment because of the size of the loan. If your down payment is less than 20%, lenders will require mortgage insurance. This limits their risk in the event a borrower defaults and the property is sold at foreclosure auction. The mortgage insurance, the cost of which is determined by a combination of loan-to-value ratio and credit score, is part of your housing expense in calculating DTI.

Credit Score

Your credit score will determine the rate you get. Lenders selling their loans to Fannie Mae or Freddie Mac use “risk-based pricing.” This means that they consult a table containing credit scores on one side, and loan-to-value across the top. Where a borrower’s two numbers interest, the lender will determine how much to adjust the interest rate.

The minimum required score for a conventional loan is 620. A borrower with that score can still get approved for a loan, but their rate will be approximately .75% higher than for a borrower with a 740+ score. The same holds for the cost of mortgage insurance. A borrower with a 740 score and a 90% loan will pay .41% for monthly mortgage insurance. A borrower with a 620 score will pay 1.10% for the same kind of loan.

Your other debt service will also determine how much you qualify for because the lender (actually, Fannie and Freddie, one of whom will almost certainly buy the loan) will limit your total obligations to 50% of your gross monthly income.

Some examples

Now that all the theory is out of the way, here are some examples, all based on a 50% DTI:

  1. You have 20% cash to use as a down payment, plus a bit more for closing costs. Your credit score is 740 and you owe $500 in other debt payments. You can expect a rate of about 4.875% and will qualify for a purchase of about $740,000. Your monthly payment will be $4,000 including taxes and insurance
  2. You have 10% cash available to put down. Other variables are the same. You’ll qualify for $640,000 with a total monthly payment of..surprise—$4,000. The reason for the difference in price is the larger loan amount and $200 a month in mortgage insurance
  3. You have 5% cash to put down. Now your loan is larger and the cost of mortgage insurance is higher, so your maximum is going to be $600,000.

Can you buy in the Bay Area?

There are those who have said “fugeddaboudit” about buying a home in the Bay Area. While prices in Silicon Valley have gotten, well…stratospheric the last couple of years, there are plenty of other decent areas where prices are within your reach. In Contra Costa County, nearly half the active inventory is priced below $600,000. For Alameda County, it’s about 1/3.

The Secret Sauce: Tax Credits!

There is one other thing that can help you, if you’re a first-time buyer. You qualify for that status if you have not owned your principal residence for at least three years. As a first-time buyer earning less than $125,000 (or $146,000 if your houshold is 3 or more), you qualify for Mortgage Credit Certificates (MCC). This is a little-known program that will allow you to claim 20% of the mortgage interest you pay as a tax credit—it comes off the bottom line of your taxes. Because the credit is a specific amount, we treat it as income, which will further increase the amount a buyer can qualify for. You likely qualify for a higher purchase price than the MCC maximum, but if you stay within the maximum, which is $585,700 for most of the Bay Area counties, it will save you thousands annually. You get the credit every year that you own the property and occupy it as your primary residence. You can get more information in our MCC video. Have a look!

 

A change to report!

Tax Reform and You

By now, you have already seen dozens of articles about the recently-passed “Tax Reform and Jobs Act.” While it has not yet been signed into law, there is a great deal of speculation about the final bill. Specifically, people wonder about how the changes will affect the ownership of real estate.

Every situation is different, and you can’t rely on the on-line calculators that claim to show you how much you’ll save under the tax plan. Taxation is necessarily complex, but this article should give you some guidance about how to arrive at your own conclusions—based on the actual bill, not on some pundit or politician’s speculation about it.

The up-front disclaimer

Your humble author is not a CPA, tax preparer or tax lawyer. While I make every possible effort to be sure what I say is correct, you should not consider any of this to be authoritative tax advice. Rely on your regular tax person for that. If you (or your tax person) find any errors in this article, feel free to reach out to me directly.

Income tax is quite a bit more complex than it may appear from this article; but even though I am intentionally over-simplifying it a bit, you should come away from reading this with a good understanding of how income taxes work—and, more importantly, you should be in a better position to determine what, if any, benefit there is for you in the new tax law. Be patient as we work through the basics.

How taxes work

In order to understand what benefits you may receive from the new tax bill, you should know how our progressive tax system works. “Progressive” means that each portion of your income is taxed at a progressively higher rate. I’ll use a filing status of “married filing jointly” throughout, for simplicity.

The tax on the first $19,050 of income is taxed at 10%. From $19,051 to $77,400, it’s taxed at 15%, and so on. The percentage is called the “marginal tax rate.” It is not your overall tax rate—the percentage of your income that you actually pay.

The table is arranged to simplify your calculation. Here is an example:

Your taxable income is $100,000. That means you are in the 25% bracket—you are above $77,401 but below $156,151. You’ll pay base tax of $10,658 plus 25% of the income above $77,400. That’s $22,600. 25% of that amount is $5,650. Your total tax is $16,308, which is an overall rate of 16.3%.

Deductions, exemptions and credits

You are allowed to reduce your gross income by certain deductions and exemptions to minimize the income tax you owe. Here is where they come into play.

An “exemption” is what used to be called a “dependent.” Each exemption is worth $4,150 (2018 schedule before the tax bill). For a married couple, you’ll get two exemptions, for $8,300, plus one for each dependent child.

“Deductions” are other items you will use to lower your taxable income. If you own a home, you may choose to deduct the mortgage interest you paid, along with property taxes and state income taxes. There is also a “standard deduction” you will use if it’s more than the total of the things you can itemize. It’s $13,000 for a married couple filing their return jointly.

Subtracting exemptions and deductions from your Adjusted Gross Income (AGI) give you taxable income—the number used to calculate how much income tax you owe.

Finally, you may receive tax credits. These reduce your tax liability on a dollar-for-dollar basis. One popular tax credit is the child credit, where families are able to deduct $1,000 for each child in the household 17 years of age or younger. Another is the Mortgage Credit Certificate (MCC), which allows a qualifying first-time buyer to claim a percentage of their mortgage interest (currently 20% in California) as a tax credit.

One simple scenario: A married couple with one child, filing jointly. They earn $100,000 annually and do not have enough deductions to itemize, so they’ll use the standard deduction. Their income tax numbers will look like this:

One more scenario before we look at the changes. Our young family just bought a home, so they have some interest and property tax to deduct. Let’s say they also paid $2,000 in state income taxes. If the total of these items is more than $13,000, they’ll itemize their deductions on Schedule A of their tax return.

They bought their home last year for $530,000. It’s their second home, so they were able to put 20% down. They paid $18,000 mortgage interest and $6,500 property tax. They’ll itemize these, along with the $2,000 state income tax. Their situation will look like this:

Because they own a home and have enough individual deductions to justify itemizing, they reduce the taxes they owe by $2,025, or about $170 per month. This is the tax advantage of owning their home: the difference between what they would pay as a renter (standard deduction) and what they’ll pay as a homeowner (itemized deductions).

Ch…ch…ch…changes

On January 1, 2018, the new tax code will presumably take effect. While it is a massive bill (1,097 pages), written by a bunch of lawyers, here are the main changes as they will affect you. We’ll also list some items that will not change even though either the House or Senate version may have originally made a change. These items are from the text of the Tax Reform and Jobs Act itself.

Old System

New System

Mortgage interest

You can deduct interest on the first $1 million of loan.

You can deduct interest on the first $750,000 of loan
Equity lines

You can deduct interest on up to $100,000 of loan placed on the property after its purchase, such as a HELOC

You can no longer deduct interest on a HELOC
Property and state income tax

You can deduct the amount of property tax and state income tax you paid

You can deduct up to $10,000 for the total of property tax and state income tax
Capital gains on selling your home

You can exclude up to $500,000 in gain ($250,000 for a single person) as long as you have occupied the home for 2 out of the previous 5 years

No change. There was a proposal to change the requirement to 5 of the previous 8 years, but it was removed from the final bill
Mortgage Credit Certificates (MCC)

These allow first-time buyers of low and moderate income to claim a tax credit for 20% of the interest they pay for as long as they occupy the home as their personal residence

No change. The House version eliminated MCC, but that provision was removed in the final bill

Non-Real Estate Provisions

Personal exemption

$4,150 per person

Repealed—no more personal exemption at all
Standard Deduction

$13,000 (married filing jointly)

$6,500 (single)

$24,000 (married filing jointly)

$12,000 (single)

Alimony

Deductible, but recipient claims it as income

No longer deductible. Recipient no longer claims it as income.
Estate Tax

Tax applied to estates valued above $5.49 million ($11 million for married decedents)

Exclusion raised to $11.2 million for single decedent
Pass-through Income (corporations and LLCs)

No provision for any adjustments

20% reduction of pass-through income claimed, but with some limitations and conditions. Essentially, someone who owns a corporation whose income is reported on their personal tax return, that income will be treated at a lower rate than ordinary income. High earners, such as high-producing real estate agents and other professionals, will save a great deal of money with this provision
ACA insurance mandate

Those who do not have health insurance will pay a fine, which was deemed by the Supreme Court to be a form of tax

The ACA mandate is repealed effective 2019
Tax brackets

Seven brackets, ranging from 10%-39.6%.

A taxpayer reaches the top bracket with taxable income of $480,051

Seven brackets, ranging from 10% to 37%.

A taxpayer reaches the top 37% bracket with $600,000 taxable income. Someone earning $480,051 would see their tax bracket drop to 35% compared to the existing law

For those seeking a more detailed summary, visit “Tax Buzz” or the National Association of Realtors summary. This page is focused on how the law affects homeowners and real estate agents.

How the changes affect you:

The three-person household we have used for our example would see their taxes change like this:

   

If they don’t itemize their deductions, they’ll see their taxes go down because of the lower marginal tax bracket and the doubled child credit. The credit is temporary: it expires in 2025.

If the family can itemize their deductions the picture looks like this:

   

The total deductions the family can itemize under the new system amount to $2,500 more than the standard deduction. We have listed that as “additional” on the grid. They will reduce their tax liability by $766, compared to the $2,491 they would save if they were unable to itemize their deductions.

Where to go from here

If you want to examine different scenarios for yourself, do this:

  1. Print out the old and new tax tables from this page
  2. Write down your gross income for “old” and “new” scenarios
  3. Calculate your “old” taxes using either itemized deductions or the standard deduction as appropriate
  4. Calculate the “new” taxes in the same way
  5. Compare

If you are handy with a spreadsheet, you’ll save a great deal of time, at least with the simple math part.

I’ll reiterate: I am not a CPA, tax preparer or tax attorney. I do my best to be accurate, but you should not consider any of what you have just read to be tax advice. You should get that from a licensed professional, not Some Guy on the Internet (me).

You are welcome to reach out to me, however. My direct line is 925-383-2846. If I am unable to pick up, please leave a message.

Joe Parsons